ECB’s New Look at Leveraged Lending Transactions

Published on January 19, 2018 by Ayoma Peiris

The new norm of low interest rates in Europe has paved the way for a strong recovery in leveraged lending transactions. This, together with increasing borrower-friendly conditions (e.g., an increased level of leverage, covenant-lite structures), suggests that lenders are becoming more lenient in their credit policies. In response to this, the European Central Bank (ECB) published a new set of guidelines in May 2017 (similar to the US guidelines in 2013), to improve understanding on which transactions should ideally be classified as leveraged lending transactions.

Any transaction that meets at least one of the following conditions qualifies as a leveraged transaction

• The borrower’s total debt ^[1] to EBITDA ^[2] (post-financing leverage) is greater than 4.0x

• More than 50% of the borrower’s equity is owned or controlled by one or more financial sponsors^[3]

These guidelines are by no means a trap to cut down every avenue available for leveraged borrowers to obtain financing solutions. Rather, they aim to introduce consistency to the risk management practices followed by lenders and to harmonize the definition of leveraged deals.

Transactions exempt from the above ruling include (1) loans to natural persons, credit institutions, investment firms, and public- and financial-sector entities, (2) loans where consolidated exposure of the credit institution is < EUR5m, (3) specialized lending loans, (4) trade finance, (5) loans to investment-grade borrowers and SMEs.

The ECB is of the view that highly leveraged transactions (>6.0x) should be rare and should ideally be escalated to the highest form of risk committee or a similar senior decision-making layer.

The new ECB guidelines will come into force in November 2017 and will likely alter the lending landscape in several ways. Non-ECB-regulated lenders (e.g., Japan, post-Brexit UK) are likely to be some of the main beneficiaries, as they will have the opportunity to engage more in leverage lending and benefit from improved returns. This has become quite the trend as banks try to compensate for lower interest income earned from ordinary non-leveraged transactions. Furthermore, non-bank lenders with a good credit standing are likely to borrow from banks and use that funding to grant high-risk loans, as was the case in the US. In other words, instead of eliminating the risk associated with leveraged lending, the risk will simply transfer from banks to non-banks, continuing to challenge the stability of the financial system. Moreover, the 90-day limit for completion of syndication deals is likely to adversely affect M&A financing, which usually takes months to complete owing to regulatory constraints. In such an instance, banks would actually be penalized for underwriting such deals. Nevertheless, it will be interesting to follow how the ECB monitors banks’ compliance with the above guidelines, especially given that the size and risk profile of leveraged transactions will be evaluated in proportion to a bank’s assets, earnings, and capital.

For more on our Commercial Lending services which facilitates compliance with this new regulatory change, visit: https://acuitykp.com/solutions/commercial-lending/

References

^[1] Total debt refers to total committed debt (drawn and undrawn amounts) and any additional debt permitted by loan agreements.

^[2] EBITDA refers to earnings before interest, tax, depreciation and amortization. Any enhancements to EBITDA should be justified and reviewed by a function independent from the front office.

^[3] A financial sponsor refers to an investment firm that undertakes private equity investments in and/or leveraged buyouts of companies with the intention of exiting those investments on a medium-term basis.

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